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Lesson 3: the Green Arrow Graph

The Green Arrow Graph was originally something I cobbled together in a hurry to explain to my buddy Barry why (at that time) it was not the best time to put new money to work. It was never meant to be a staple indicator but the simplicity of it all has made it a hit with CME4PIF Market Comment readers and it is at least a unique indicator.

The heart of the idea is that markets are not as (some academics claim) random, they "revert to the mean" and markets move in trends or waves, so after a sell-off there are too many bargains and there is a bounce back. Or you could say when you are out of sellers there are only buyers. Well at least in a bull market that is how it goes.

There is no magic in how it works, I simply wanted to show a ratio between big stocks and smaller companies. As a market heats up, people are more likely to buy rumors and tips on little companies, where as in fear filled, unstable markets, the flight to safety pulls them into the big well known names. Since most of the market and the indexes are correlated these days it almost doesn't matter what symbols you use as long as one is an index of big firms and one is an index of smaller firms.
(as always click on any graphic to enlarge it)
There are certain ETFthat track various segments of the market, for big firms we could use DIA (tracks the DOW 30) or we could use SPY(tracks the S&P500).  I use $SPXEW the equal weight version of the S&P500. This is a proprietary symbol of Stockcharts.com but you could just as easily use the ETF called RSP to get similar data. Equally weight indexes give each company a specific share in this case the biggest 500 firms get a 1/500 share. In an non-equally weighted index the fast growing large firms gain a bigger and bigger share of the index, so in the traditional S&P 500 Apple has a huge influence. At the time of this writing Apple was over 5% of the S&P 500 index.

I learned the hard way about weighting in indexes, in the dot com boom my TSE 60 fund that was suppose to represent the Canadian markets.  As Nortel's stock price grew and grew the iShare ETF called IXU  became simply a proxy for Nortel. In case you missed that Nortel was a stock that did not end well.

Now we need to compare our big stock index with an index of smaller firms. I could use IWM an ETF that tracks the 2000 smallest firms of the some 3000 stock universe. However, I find these firms are not really what I would consider investment grade and they are dead last to be invested in. The Midcap 400 is a more middle of the road, the ETF for this is MDY but the 2X leveraged version is what I use form my graph, the symbol is MVV.

On Stockcharts.com you can make a ratio of two symbols using the colon : symbol. So the first part of creating the green arrow graph is on stockcharts.com enter the symbol MVV:$SPXEW  that is the 2X the Midcap400 vs the equal weighted S&P 500 index. But you probably could get a similar result from simply using MDY:DIA (the midcap 400 vs the DOW).

Next we smooth it a bit to make it less bumpy by making the underlying graph invisible and overlaying a 5 day exponential moving average. The result is this graph:

I think it is pretty obvious as it is, just buy when a new ramp up begins. But just in case you can't see that, I place a MACD histogram and a 20 period slope on top of the graph. OK now you are wondering what makes the Green Arrows, well, it is me of course. I draw them in about when the slope has exceeded about one vertical square.




OK lets see the Green Arrow graph in action, below here is the same graph as above but now I have placed the value of the S&P 500 above the graph. The three colors are based on the Elders Impulse System that is another way to look at momentum. The important thing is you can see that if you put new money to work at the green arrows it would have been safer than jumping in near the end of a hot bull run.



Some Limitations
If you want to use the Green Arrow Graph it is important to think about what it is you are measuring. First off, you will note it says when to buy, but not when to sell. Yup that is right, I designed it that way. So before you use this tool, you should determine your own exit strategy,  I often use trailing stops but that is another school article on its own. You also could play a more long term view, then you might look at school lesson one -- the bull and bear lines and exit when the market turns bearish.

Speaking of which a Green Arrow is not a license to defy the market trend. This is a very short term market indicator. You must also understand the bigger trend. This graph just tells you investors are favoring smaller cap over larger cap stocks. There were many points in every major market downturn that some small cap buying occurred. So be sure to look at the big picture, like the Bull and Bear lines before you decided a Green Arrow represents a relevant market opportunity.

Also while I am handing out warnings, just because I am measuring a 2X ETF it is not a suggestion to buy these. Leveraged ETFs a very unstable and in the long run can become worthless. Read This before buying juiced ETFs.

So there you have it, the Green Arrow Graph is a novel technical analysis tool to read the equity markets. Keep a list of you favorite interesting investment opportunities -- ones that are positively correlated to the economy (in other words this is not an indicator to buy bonds) and buy, buy, buy from your list when the Green Arrow arrears!







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